Commentary

Insiders are buying — and that’s good news

Commentary: How to profit from those in the know

After a turbulent week, investors could be forgiven for believing the stock market’s prospects are bleak. But the recent actions of certain corporate insiders provide reasons for hope.

That is because companies’ officers and directors are buying shares, suggesting they believe their stocks are undervalued. Some researchers believe this has positive implications for the overall market as well.

The reason to pay close attention to corporate insiders is that they presumably know more about their companies’ prospects than the rest of us do.

This presumption has been borne out by many academic studies over the years, which have shown that companies where insiders are buying tend to beat the market, with just the opposite the case for companies where insiders are selling. Another finding is that the market as a whole tends to do better when insiders as a group are buying more than they are selling.

Insiders currently don’t appear to be favoring the buy side. Over the eight weeks ended June 14, in fact, insiders have sold five times as many shares as they have bought according to the Vickers Weekly Insider Report, a publication of Argus Research.

But the picture painted by these data is misleading, according to Nejat Seyhun, a finance professor at the University of Michigan who is an expert on insider behavior. His argument: The bulk of those recent sales came from a class of insiders who historically have had relatively little insight into their company’s prospects.

Those insiders who tend to know the most about what the future holds for their companies have been far less inclined to sell their shares, even as the stock market touched new records earlier this month.

It is necessary to distinguish between various groups of insiders, Seyhun says, because the government’s definition of an insider includes a wide variety of investors with varying degrees of access to companies’ inner workings.

The insiders with the greatest such access are a company’s officers and directors, and Seyhun’s research has shown that the stock of the average company where officers and directors are buying outperforms the market. He found just the opposite for companies whose insiders are selling.

Also included in the insider category are those individuals who own at least 5% of their company’s shares. Typically, according to Seyhun, these insiders tend to be institutional investors, and as a group, they historically have exhibited little ability to forecast where their firm’s shares are headed.

One particularly telling statistic is what happens after these large investors sell large blocks of a company’s stock. Seyhun found that, far from trailing the market, such stocks on average actually outperformed the market by 0.7% over the subsequent 12 months.

This is why he argues it is crucial to strip out the largest shareholders’ transactions from the insider data. Once he did that, Seyhun found that insiders’ recent transactions are fairly evenly split between the sell and the buy side.

Based on his analysis of how the stock market has tended to perform in the past whenever insiders were behaving like they are today, his best estimate is that the Wilshire 5000 index
W5000FLT, -0.49%
will rise 6.7% over the coming 12 months. Though that is lower than the stock market’s historical average return of around 10%, it would be a far better outcome than the decline that many on Wall Street worry will be the result of the Fed dialing back its stimulus program.

Though the message of the officers’ and directors’ recent transactions could be positive for the broad market, there are some sectors for which even the subset of insiders in the know are selling a lot more than they are buying — particularly technology and health care, says David Miller, a senior portfolio manager at the Catalyst Insider Buying Fund, which has $3.8 million in assets and bases its trades on insider activity. Since its inception in mid- 2011, the fund has gained an annualized 19% through Thursday, versus 14% for the Standard & Poor’s 500-stock index
SPX, -0.55%
.

By contrast, officers and directors are most optimistic about energy, industrials and financials, he says.

If you want to follow the insiders’ lead and bet on a continuing bull market, one of the lowest-cost ways is by investing in the Vanguard Total Stock Market
VTI, -0.47%
exchange-traded fund, which charges annual fees of 0.05%, or $5 per $10,000 invested. If you want to bet on the three sectors insiders favor most, low-cost vehicles include the Energy Select Sector SPDR
XLE, -1.68%
, the Industrials Select Sector SPDR
XLI, +0.03%
and the Financials Select Sector SPDR
XLF, +0.14%
. Each has an expense ratio of 0.18%.

Among companies where directors and officers have been buying shares is oil-and-gas company Linn Energy
US:LINE
, which Miller recently bought for his fund. Among his reasons: Both the chief executive and chief operating officer recently bought company shares, the first by either executive since August 2011 and the largest to date for each. In addition, the company’s lead director also has been purchasing shares.

Apache Corp.
APA, -2.87%
is another energy company where several directors and officers are buying and that Miller has bought for his fund. He says it was particularly bullish that the firm’s CEO recently bought 10,000 shares, since his previous transaction — in January 2012 — had been a sale. “We have found that reversals in activity where a CEO had been selling, then reverses direction and starts buying have frequently marked a turnaround for a stock,” Miller says.

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